Crowdfunding has created its first $1bn company – how can you profit?

When Facebook paid $2bn for a virtual reality company last month, 9,522 people were probably pretty fed up.

Collectively, they had given $2.4m to the company, Oculus VR, when it launched in 2012. But when the company was sold, they got no cash from Facebook. Instead, they just received ‘rewards’ from Oculus via the Kickstarter crowdfunding website.

Oculus has done nothing underhand. These early funders were never promised shares in the company.

But the story highlights two things.

Firstly, that companies backed by ‘crowdfunding’ have the potential to turn into real winners.

And secondly, that if you do contribute to crowdfunding a company or project, you need to be very clear about what you’ll get in return.

What is ‘reward crowdfunding’?

Let’s start by looking at ‘reward crowdfunding’. This is where you provide funding to a young business, charity, individual or project. You don’t get shares in return, just a reward.

Basically, anyone contributing to these projects is doing so because they’d like to see these projects succeed, not because they are looking for a financial return.

In the Oculus example, funders who gave $300 received a ‘developer kit’. This meant they could get a head start on designing games for the first Oculus virtual reality headset. Other rewards were available for different sums – if you gave $25, you got the proverbial T-shirt.

The two big reward crowdfunding sites are Kickstarter and Indiegogo. If you’ve never been to these sites, it’s well worth taking a look. You’ll see a wide range of different people looking to raise cash from donors. In fact, last month Kickstarter said that over a billion dollars in total have now been pledged to projects on the site, with around 5.7 million people contributing.

The beauty of reward crowdfunding is that you can raise small amounts of money in a relatively simple way. (I’m not saying it’s easy, but just one person can launch a campaign and make it work.) So from an investment point of view, if you’re looking to raise money for a project, it’s definitely worth investigating.

I recently heard a ‘howtoacademy’ presentation from a woman called Crista Cloutier in which she outlined how she had raised $18,000 to launch a small art business. It had clearly been a fairly stressful experience for her, but, in the end, she got the money to get her business up and running.

One interesting point was that she got the majority of funding from people she already knew. Running the crowdfunding campaign was a great way to tap her pre-existing ‘network.’ So if you want to raise money to start a small business or other venture, reward crowdfunding could be the way to go.

What is ‘equity crowdfunding’?

However, if you have funds to invest, and you fancy getting more than a T-shirt, you should look to equity crowdfunding. This is where you invest money in a business via an equity crowdfunding website, and you get shares in return.

It’s important to flag up the risks upfront. These businesses are usually very young, and they’re not listed on any stock market. So if you want to sell your shares, you may find it very difficult, if not impossible. This is a very high-risk area for investors.

That said, it’s also rather fun. There are three main equity crowdfunding sites in the UK: Seedrs, Crowdbnk and Crowdcube. Of the three, I know Seedrs the best. I’ve invested in four start-ups on the Seedrs platform as well as putting some money into the Seedrs business itself.

I’m particularly excited about my investment in Shareight, a smartphone shopping app. Sadly, it’s now closed to new investors.

But I’m sure there will be plenty of exciting opportunities in the future, and the good news is that the sector is starting to mature. All three of the equity crowdfunding sites I’ve mentioned are now regulated by the UK’s financial watchdog, the Financial Conduct Authority (FCA).

The FCA has said that the sites can promote investments to a fairly wide range of investors. These include people who confirm that they will not invest more than 10% of their net investible assets in crowdfunding ventures.

What are the other crowdfunding avenues?

If equity investing feels too risky for you, there are some other options. One is Abundance Generation where you can buy debentures offered by solar and wind energy projects in the UK (a debenture is similar to a bond).

Right now, you could invest in a wind project in Cornwall that should pay you an annual return of roughly 9% for many years to come. Of course, there are risks to this – these aren’t government bonds you’re investing in. If you’re interested, you can find out more about Abundance in this article.

Then there’s peer-to-peer lending where you lend to small businesses. FundingCircle is probably the best known player – it has so far raised £256m for small businesses. Right now you can probably get an annual return of around 6% or more via this route.

The default rate is impressively low – just 1.4% of loans have defaulted and not been repaid so far. However, I do worry that this default rate might rise if we went back into recession.

The risk of default should, in theory, be lower on a new site called FundingSecure. This is effectively a peer-to-peer pawnbroker. You can lend money to an individual or business where the borrower provides security in the form of an asset. Examples include jewellery, cars and antique books.

Because there’s a secured asset, most lenders should at least get their money back on FundingSecure. That said, it’s very early days for this platform, so it may be worth holding back for a year or so. Then we’ll have a better idea whether FundingSecure is likely to survive in the medium term.

This is just a sample of the options out there. Crowdfunding and ‘alternative finance’ in general is a bit of a boom area right now, with new sites launching all the time, each with its own gimmick. That means we can expect some fantastic opportunities and also more than likely some horrendous blow-ups at some point in the future.

But one thing’s for sure – it’s an area any active investor should be keeping a close eye on. We’ll shortly be launching a new page in MoneyWeek magazine, dedicated to the sector – look out for it. And if you’re not already a subscriber, you can get your first three issues free here.

When it comes to buying shares and funds, there are several investment platforms and brokers to choose from, with varying fees and charges. Find out which is best for you.

BrianL51

The reason I favour Funding Circle over Crowdcube (peer-to-peer lending over equity crowdfunding) is that I can’t see how to avoid getting seriously diluted when a start up takes off. Pre-emption rights are OK, but to keep up you may need more funds than you have available.

I too am not wholly convinced of the sustainability of Funding Circle’s low default rate. Some of the comments on their blog by members of their assessment and default teams show that they’re not clear whose interests they should have closest to their hearts. They seem as happy to see themselves as the saviours of borrowers as they are protectors of lenders. I would be happier with them if they were incentivised (through their pay packets) to keep default rates within bounds for the various risk levels to which they allocate borrowers. If such incentivisation were in place, they would be less likely to grant A or A+ risk status to would-be borrowers. Correctly assessed, such borrowers should only default in the event of a blue moon.

steveH

I so much prefer p2p/p2b, as opposed to stockmarket smoke and mirrors

For p2b business loans look also at Thincats which has by far the best crowd due diligence (q&a). £1K minimum investment per loan, 1-5years 8-12%ish.
Assetzcapital p2b renewables bridging loans
p2pindependentforum website is useful

Funding Circle seem to be doing better with company defaults than they were a couple of years ago. I joined FC pretty soon after it started, but withdrew most of my money 2 years back when the bad debts on my loans just grew and grew. I still got out in profit (just). Went back to it in mid 2013 and have been pleasantly surprised with the default rates, much lower !. Have to say though that lending rates seem to be on the up-and-up. Good for lenders, but suggests to me that FC have more borrowers than they have funds to deliver attractive rates to firms. If that goes on, firms won’t come to FC.

Clive

@ steveH

Thincats isn’t for me, as I’d want to be lending to 50+ firms for the diversity, but don’t have the necessary £50K.

CT

Have a read of this case study which is from the Entrepreneur’s perspective. It just shows how good business ideas can be lost via traditional methods of sourcing finance. Crowdfunding both recognised and brought the Pizza Rossa business plan to life.

I do not understand why Abundance get lumped in with crowdfunding? They are more akin to thincats, but because they use debt securities (debentures) rather than loans they are arguably lower risk. Debentures require more due diligence and they are also issued by plc rather than private companies. Abundance also have a low minimum investment amount making it easy to build a portfolio

What i also like is their focus on operational renewable energy plants, i quite like renewables as an asset class as they generates a relatively low risk income stream.

FF

I agree. For investors, it is easier to invest than to exit. However there is a new online site called Liquity which aims to bring buyers and sellers of secondary market private company shares together. This site is targeted at business angels, HNW, VCs and will prove useful to to those who want to exit or enter into a private company investment. It does not provide advisory services but will partner with FCA authorised companies (where necessary) to provide those, e.g. valuations.

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